In a VoxEU post, Guillermo Calvo argues forcefully that rising commodity prices are the result of excess liquidity rather than supply and demand.
From VoxEU:
Here, one of the world’s leading macroeconomists argues that the explosion of commodity prices is the result of a very real global financial storm associated with excess liquidity in several non-G7 countries and nourished by low G7 central banks’ interest rates. The commodity price explosion is a harbinger of future inflation.
Oil, metals, and now food prices are heading to the sky with a virulence that is hard to rationalise on the basis of world output growth – not even on the basis of China’s and India’s fast growth, let alone the expected global slowdown. This phenomenon has been accompanied by much higher transaction volumes in forward markets. Thus, analysts and policymakers have been quick in pointing an accusing finger at the proverbial speculator, who has even been declared persona non grata in some countries, like India, where commodity futures have been banned.
The thrust of this column is that we are not going through another self-fulfilling bubble. Today’s explosion of commodity prices is the result of a very real global financial storm associated with large excess liquidity in several non-G7 countries and nourished by low G7 central banks’ interest rates. This price explosion could be a leading indicator of future inflation driven by fundamentals.
Commodity stockpiles
Absence of a substantial increase in physical commodity inventories has been mentioned as evidence of absence of speculative activity (by Martin Wolf and, more guardedly, Paul Krugman).1 But that is not valid. Suppose, for the sake of the argument, that the demand for commodities for current consumption or production is completely inelastic (food and oil are good examples in the short run). If speculators attempt to stockpile commodities, commodity prices will go up. And they will go up as much as necessary to discourage the speculators from adding to their stocks, that’s all. To keep matters simple, I will zero in on that special case and explain what drives speculators to stockpile so aggressively as to provoke a price explosion.
Incentives to stockpile commodities stem from the combination of low central bank interest rates (especially in the US) and the growth in sovereign wealth funds. The latter, in my view, is the crucial factor. Sovereign wealth funds have been created partly with the intent of switching the composition of government wealth from highly liquid but low-return assets to more risky but much more profitable investment projects. Thus, their attempt to get rid of excess liquidity resembles the econ 101 exercise in which the student is asked to trace the effects of a portfolio switch away from money and into capital. The answer is – of course – higher prices. I will return to that in a moment after I explain why central bank interest rates are also important.
Interest rates and prices
Take the Fed rate (i.e., the Federal Funds rate). Recently, the Fed rate has been sharply lowered and the market does not expect that it will be raised with equal impetus in at least one year hence. This must certainly add to sovereign wealth funds’ determination to switch away from US Treasury Bills, which, incidentally, helps to explain the suddenness of the price rise. However, Treasury Bills do not exactly fit the characteristics of the econ 101 money. If the demand for Treasury Bills goes down, their price will fall until Treasury Bills’ holders find the yield attractive enough to drop their other investment projects. In this case there would be no upward pressure on the general price level, but the effective Fed rate will likely rise. This, in turn, will induce the Fed to pump in more liquidity through open market operations, creating econ 101 money (actually, high-powered money) through the purchase of Treasury Bills. Therefore, low and momentarily pegged central bank interest rates imply that the fall in the demand for Treasury Bills results in an expansion of the money supply. Now we can confidently employ the econ 101 result to argue that the portfolio switch implies higher prices. Notice that this argument does not rely on the more standard concern that the Fed is pumping in liquidity to rescue the financial system. This may be a problem in the future but, to the extent that the Fed is simply substituting safe assets for risky assets in banks’ portfolios, the policy need not result in a sharp increase in monetary aggregates and prices.
Not all prices show the same degree of flexibility. Commodity prices are at the high end of the flexibility spectrum, while wages are likely to be on the other. Thus, the price rise phenomenon will bring about a change in relative prices in favour of commodities. Interestingly, however, eventually, as the slow-moving prices catch up, these sharp differences across prices will disappear and a much more uniform price rise phenomenon will materialise. Thus, when analysed from the perspective of some future time, this whole episode will look very much like a bubble in the commodity market, a market mirage, even though what is behind it is a fundamental factor: lower demand for liquid assets by sovereigns like China, Chile or Dubai. Overshooting of commodity prices could be large because even though sovereign wealth funds are not large in terms of wealth, they are quite large with respect to monetary aggregates. For example, several reports estimate that sovereign wealth funds’ assets under management exceed US$3.5 trillion and are growing fast,2 while US M1 and M2 are, respectively, US$1.4 and US$7.8 trillion as of April 2008.
Inflation to come
However, US monetary aggregates do not yet show an increase as sharp as that of commodity prices.3 Should we conclude that the above argument has feet of clay? There are at least two different answers to this potential objection. One answer is that under well-developed financial markets the expectation that a portfolio switch with the above characteristics will take place could trigger anticipatory price increases. The second answer hinges on the observation that Treasury Bills are possibly closer to money than to pure bonds (especially under high counter-party risk). The relevant money concept could be an aggregate involving M2 and Treasury Bills, for example.4 Thus, the portfolio shift, unaccompanied by a change in the Fed rate, would be tantamount to an increase in money velocity of circulation – another econ 101 experiment with similar inflationary implications. In this case, M2 need not change!5
In short, my conjecture is that commodity prices are the result of portfolio shift against liquid assets by sovereign investors, sovereign wealth funds, partly triggered by lax monetary policy, especially in the US.6 Is this a harbinger of higher CPI inflation? If interest rates continue to be low, my answer would be a resounding yes. But there is probably room for an effective anti-inflationary battle. This will likely call for a sharp rise in interest rates and will enhance the risk of deepening recession, particularly if financial vulnerabilities have not been resolved. Thus, policymakers should seriously start worrying about inflation and stop chasing imaginary destabilising speculators.
Footnotes may be found here.
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Since most sovereign currency prodivers have zero or negative real rates, per recent comments by others on this blog, we will have massive over liquidity relative to assets or demand, surprise, surprise. And this is what the end of the gold systme has come to (not that I have any fondness to restore it): everyone’s money is loose, just some sums are looser than others. In the Thirties crash, everyone jacked up tariffs and most demanded payment in gold for a time. In the Great Dislocation of the Nineties and the Oughts, everyone is pumping vaporcred into their economies through great big hoses ‘out the door on the left’ of their central banks. An interesting experiment, but the living of it is lively, no?
I am sympathetic to most of Calvo’s argument, but there is a large undemonstrated assumption within it. He is saying, in essence, that SWFs are playing the commodity markets heavily: where is the proof? His reasoning for why they are/might be seems good, to offset bad yields on other assets, but it isn’t shown here, or well-described from what all information seems to be available, that it is _SWFs_ playing commodities heavily. Rather, it seems more nearly that it is the ibanks and hedgies playing commodities, though for essentially the same circumstances he attaches to sovereign funds. Hmmm.
But I really like this point Calvo makes: “The relevant money concept could be an aggregate involving M2 and Treasury Bills, for example.4 Thus, the portfolio shift, unaccompanied by a change in the Fed rate, would be tantamount to an increase in money velocity of circulation – another econ 101 experiment with similar inflationary implications. In this case, M2 need not change!” If I follow what he is saying, then the T-bills swapped out by the Fed are more nearly cash-like than bond-like given present counterparty concerns on the swapped _out_ CDOs—and so functionally less ‘sterilized’ than the face-for-mark values would imply. I think that is a very relevant concern, not least because top tier banks acquiring T-bills may be using them . . . to play commodities; certainly, they don’t appear to be using them much for ‘normal lendgin,’ of which little seems to be happening. Hmmmmmmmmm.
Now that the issue is settled…and it’s “apparent” that the rise in commodity prices are the result of excess liquidity, as opposed to supply and demand…I was wondering if you could help me out with another conundrum that’s been bugging me for quite some time:
Which comes first—the chicken or the egg?
All this talk about whether the increase is due to excess liquidity or demand is absurd…and about as fruitful as discussing, chickens, eggs or trees falling in forests with nobody around to listen.
The two phenomena develop didn’t develop in seperate vacuums?
One begets the other until maturity, and then— mitosis.
After the split, we have all this hand wringing, as if the two have been seperate all along.
I’m not saying there haven’t been real policy bluners (understatement), but this type of “analysis” is weak.
If you simply look at the spread between CPI and PPI (assuming you belive the numbers) it has been persistently negative. it just so happens that the overloved productivity word coincides with corporate profuits at record high percentage of GDP and stagnant wages. That said, if you look at PPI components it is intermediate goods that are bearing the brunt of the syrocketing crude prices. Finished goods are showing some strain and CPI is downright medicated in comparison. Productivity is a palliative term; kind of like someone slapping you on the back and telling you what a great job yuou are doing while they steal your wallet. Back to CPI, the PPI composition is screaming pent up inflation pipeline. You are beginning to see the cracks with Dow Chemical, Airlines (Jetblue and Southwestern just annoucned they are removing their low price caps), food commodities etc…The signs are everywhere. And let’s e clear, if and when we cycle through the hgiher prices, the governement will claim victory, which will simply mean you have been devalued. The most perves part of t5his whole debate is how pundits get on TV and gloat about wage compression. If ever there was a perfect commentary on the bankruptcy of discourse this is it.
I differ with you there, Dan, for two (at least two reasons). For one, supply and demand questions in economics are at present really very poorly framed from a systemic standpoint. We have a real opportunity in the present crisis to get a better theoretical understanding of them because we are seeing extreme behaviors in the financial system, a ‘laboratory experiment’ on a grand scale. For another, we have to drink the result: real policy interventions are presently being made based upon whether, say, commodity prices are being driven by demand or by too much credit. The simple fact that the best educated minds and practical experience in the world cannot come to a consensus regarding whether incipient financial system conditions in the US are deflationary or inflationary is diagnostic that present theory is weakly grounded and needs rethinking. If our rethinking is cumbersome, well it is what it is because we are who we are.
“The simple fact that the best educated minds and practical experience in the world cannot come to a consensus regarding whether incipient financial system conditions in the US are deflationary or inflationary is diagnostic that present theory is weakly grounded and needs rethinking.”
Amen
So are the Saudi and and Dubai SWFs buying oil futures through Morgan Stanley? Brilliant, bloody brilliant.
I’ll second the Amen to Richard’s point that present theory is weakly grounded.
My point is that targeting “excess liquidity” in a vacuum isn’t just cumbersome–it’s counter-productive.
You said it yourself—the world cannot come to a consensus on the issues at hand—and this is with the benefit of hindsight.
“Excess liquidity”. It’s one of those phrases that appears to stand on it’s own with a definition that’s self-evident…as in, “Well, it’s obvious. Excess liquidity is bad. We must not have this!”
But “excess liquidity” is anything but easy to define.
This type of analysis strikes me as a call to arms, not against a word (as in…”terror” for example), but against a phrase. And it’s prosecution will lead to the same damnable result.
I think it’s counter-productive, because policy makers (and people in the blogosphere) will actually think they are making a difference, when it’s really just another example of impotent aggression and a rage against an ethereal machine.
We’ve gone from explosions in tulips to a very real chance of a thermo-nuclear explosion on the derivative value of insurance on the derivative value of those same tulips.
Color me a skeptic…but I just don’t think the good fight against “excess liquidity” is going to make a damn bit of difference.
“Excess liquidity” is econ-speak for “I WANT MORE!”
Here’s another chicken and egg type question:
Is it narcissism or naivete that leads us to believe we can divide and conquer greed from ambition?
Instead of “excess liquidity”, how if the government offers a personal finance seminar. It’ll quick and easy, as the message will be:
“The next time you hear it’s ‘different this time’, or you read about TV repairmen making bundles buying selling [insert asset] sight unseen….run! Run for the hills!”
“The simple fact that the best educated minds and practical experience in the world cannot come to a consensus regarding whether incipient financial system conditions in the US are deflationary or inflationary is diagnostic that present theory is weakly grounded and needs rethinking.”
I would disagree. it is not that there is not a consensus, all know what is happening and what led to the current situation. The probelm is not rethinking dogma, it is accepting that someone is going to lose. Think who got the better end of the china reserve build vs. US consumption total return swap? this is about who takes the loss. The US is currently using its we are to big to fail mantra, they have to invest here, to pursue policies that are suboptimal for the other 6 billion people. not sustainable. This is about who takes the loss and how you deal with the massive debt export machine that is the USA. Period. Notwithstanding the dirty science, one needn;t overthink this: US monetary policy has been a disaster and so far the rest of the world has tolerated the bullying. Overt self interest wins, and for the moment the US remains the big guy on the block, although the gap is shrinking. As they say, be careful of the toes you step on today, might be the ass you have to kiss tomorrow.
“Absence of a substantial increase in physical commodity inventories has been mentioned by PK as evidence of absence of speculative activity”
An equally valid counterpoint might be:
” the absence of a substantial decrease in physical commodity inventories has been mentioned as evidence of speculative activity”
Contemporary economists(read:Ivy league) seem almost incapable of critical thinking. Was it a shortage of housing that led to the housing bubble ? No.
Was it speculation fed by liquidity, yes.
Ugh. Higher commodity prices are the CONSEQUENCE of higher inflation, not the CAUSE of it.
Why oh why has everyone forgotten that inflation is a monetary phenomenon. Keynsian price inflation isn’t even well defined and it’s so painful to read people talking about oil causing inflation.
Dollar goes down, oil goes up, cost of living skyrockets and hedge funds play God in a reckless market filled to the brim with collusion. Right now we have hedge funds hording fuel in supertankers in an effort to push up prices, as they hedge wheat, corn and dollars in a great effort to destroy the global economies. Meanwhile, the retarded Bush Coup plays along with Senate and Congress as sideline investors — all of whom will do anything in an effort to make more cash.
Bull again. Your “readers are invited to correct me” clearly refers to whether the amount of incremental collateral is $4 billion, not whether the collateral reduces claims paying resources.
No, it is (soon to be was) the first sentence of the paragraph. The first sentence of a paragraph is the governing thought. Putting it as the very opening of the sentence at the start of a paragraph made it prominent and indicated it applied to the entire paragraph.
we are seeing extreme behaviors in the financial system
The Federal Reserve is the mechanism of transmittal of extreme behavior (or at least the results of extreme behavior) from Wall Street to Main Street.
If an investment bank blew up and took out 10 other investment banks and 1000 hedge funds, I think Main Street would be better off. The Fed thinks differently though.
Somehow an argument that rests on 1) SWFs speculating in commodity futures and 2) an increase in velocity just doesn’t sway me. The one SWF that we know anything about–Norway–got hosed in the first quarter.
Just a note to say what a superb blog you have. Thank you so very much for your work.
Yves Smith + Adam Smith = Adam & Eve?
I think your argument is reasonably sound, except for its discounting “imaginary destabilising speculators.” Michael Masters testimony before the U.S. Senate Committee on Homeland Security and Governmental Affairs on May 20, 2008 is a rather compelling read (if nothing else, read the first paragraph on p.4)
Is there any argument futures markets set prices for many physical commodities?
Let’s be clear, however. Speculators who use futures markets to hedge their physical interest in a given commodity serve both a useful and desirable purpose.
On the other hand, speculators chasing investment yield through increasing allocations in Index Funds are serving no useful purpose. Indeed, as we see with our own eyes, the result is socially destructive. Therefore, those firms promoting such investments (Goldman Sachs and Morgan Stanley to name two) should, first, be held in contempt and, second, be regulated.
Now, could the destabilizing impact Index Funds are having on commodities futures markets occur without monetary inflation?
Yes, of course.
However, without the help of relaxed CFTC regulation, the answer would be no, and this, with or without monetary inflation.
It is on this count, then, the FSA calling U.S. movement to gain regulatory redress over the City’s oil market “American imperialism” a knee-slapping laugh to this American. Talk about the pot calling the kettle black!
True, the U.S. Congress might seem to resemble more the Iraqi Parliament than the House Henry Clay built. However, the streets are nothing like those in Baghdad. How could they? They weren’t built by a deranged Tory aristocracy, but rather by benevolent republicans guided by wisdom codified in a written constitution…
So Vijay: “Higher commodity prices are the CONSEQUENCE of higher inflation, not the CAUSE of it.” If I stand and observe from _here_, prices are a consequence; if I stand and observe from _there_, prices are the cause. If I should strain to observe from a viewpoint where I can get here and there in a single frame of reference, prices and inflation ’cause each other,’ that is they mutually modulate their change vectors. One simply cannot get a useful perspective from, say, inside the US at the demand end alone when the imputs to price movements are global, multiple, and trajectories of change rather than sticky and well-defined values with predictable movements in response to putative exogenous shocks.
Terms like ’cause’ and ‘effect’ simply do not mean the same thing in self-organizing systems; often, those terms are functionally meaningless. That is hard to get one’s head around, I know. I’ll say it again: Systemic interactions are seldom cause and effect because different portions of a common system are not discrete from each other. Keynes and the Austrians are informed 20th century perspectives on 19th century capital flows, neither of which even in their day well-described mutual modulation in systemic processes. It is time, time and past really, to _junk_ the economics we have learned and to make an economics that uses definitions and relationships consonant with the processes represented. Think about it.
To S. at 1:54: I do not see the consensus you speak of re: the financial system, either in the US or amongst major global participants. Notwithstanding our difference there, I agree with the core point you raise in this comment, that major unrealized losses are having a paralytic effect upon policy initiatives through the last year, especially in the US, but elsewhere as well. Someone is going to take that the hit: in fact, everyone is going to take _a_ hit, and deeply wishes to minimize it, necessarily at the expense of some other financial system participant. When I call our present financial public authorities gutless it exactly because they have so far refused to designate domestic ‘hittees’ in the vain hope that the economy will come right, and they won’t have to do anything so unpopular. That is an entirely understandable decision even while it is most probably a mistaken one which will increase ultimate losses.
I am also in agreement with you, S., that US monetary policy for a generation has been a major net negative for the global financial system as a whole. But, and not that it gives me the least pleasure to in any way defend US financial public authorities who have shamelessly exploited our structural advantages over this time, we couldn’t have done it without the willing and indeed eager cooperation of ALL THE OTHER MAJOR PLAYERS since the time of the Plaza Agreements. They all agreed to back our false front greenbacks at well above what our GDP suggested its valuation should be because this allowed them to continue to optimize their pre-existing macroeconomic strategies and retain their niches rather than go through a major redo. —And we see the result now.
Frankly, the US should have had a prolonged recession/shallow depression in the mid to late 90s; I say that from a long-term modeling perspective. We didn’t. And not because of a ‘productivity miracle’ or an ‘information revolution’ or a fictitious ‘long boom.’ The rest of the world lent us the money to spin spurious ‘growth.’ When that wasn’t enough, they all edged down toward negative real rates. When _that_ wasn’t enough after 01 when we should have cycled through real losses, we went to negative real rates ourselves. But we got into this mess with a sphere full of co-dependents. . . . And now, we will all have to get out of it together. Failing that, we get a global crash, after which the most productive sovereign economies crawl back out of it first and write the terms on the New Real Deal. But that won’t be the US, and for policy makers here, _that is the problem_. So, no one in power in the US is eager to take the loss, in capital and influence, that is in the pipeline. And for sure, none of those non-leaders is going to step befoe the public and announce the Diminution of Empire (it won’t be over for forty years, give or take).